The Comeback of Private Equity

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Sovereign-wealth funds did not do it. Joe Lewis, the billionaire investor who bet and lost on Bear Stearns, definitely did not do it. Will private-equity firms be any more successful at calling the end of the credit crunch?

They seem ready to do so. TPG, a large buy-out group, led a $7 billion injection of capital into Washington Mutual (WaMu), a Seattle thrift that grew into America’s sixth-biggest bank and came a cropper in subprime mortgages. TPG is also among a trio of big-name private-equity firms (Apollo and Blackstone are the others) that are reportedly negotiating with Citigroup to snap up $12 billion-worth of leveraged loans that have been stuck on the bank’s balance sheet since the credit markets froze. A deal may be announced when Citi reveals first-quarter results on April 18th.

The transactions highlight two things. One is the changed environment in which private-equity firms are operating. Frothy markets, public-to-private deals and easy lending terms have given way to distressed prices and lesser degrees of leverage: TPG is using $2 billion of its own cash to take a minority stake in WaMu, which will remain firmly listed.

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The other is that the industry still has lots of capital to put to work, no small matter in the current environment. Funds continue to flow in. The amount of money raised by America’s private-equity funds in the first quarter of 2008 grew by 32% compared with the same period of 2007, according to data from Private Equity Analyst, a newsletter.

Distressed debt is one of the areas taking up the slack left by shrinking volumes of splashy leveraged buy-outs. Shrugging off the embarrassment of seeing one of its fixed-income funds blow up in March, The Carlyle Group this month closed a $1.4 billion fund to take advantage of bargain prices. Apollo, which has a long involvement in distressed debt, revealed plans on April 8th for an initial public offering.

Funds focused on the ailing financial sector have since last year attracted particularly large amounts of capital (see chart). That is a change. Banks are already highly leveraged, so they used to be considered less suitable for the traditional private-equity strategy of ladling on lots of debt. As borrowing has become more expensive, the accent on gearing up has softened. Buy-out types now talk enthusiastically of banks as being “pre-levered”.

Buy-out firms have to bring more to the table than a keen eye for value, however. True, they can sometimes benefit from inside knowledge. The talks with Citigroup are thought to involve leveraged loans made to TPG, Apollo and Blackstone themselves. TPG’s founder, David Bonderman, knows WaMu well, having already had one spell on the bank’s board. It may even suit private-equity firms to buy the debt of companies that then default, in order to gain control of them cheaply. But picking the bottom of falling markets is something that investors can do for themselves without paying hefty fees.

With financial engineering a fading memory, the real value of private equity lies in improving the performance of portfolio companies. “As leverage multiples go down, operational improvements will drive a higher proportion of the industry’s required returns,” says Paul Mullins of Boston Consulting Group (BCG). Despite appearances, that shift in emphasis was well under way even before last summer. BCG analysed 32 companies that had been bought and sold by European private-equity firms before the crunch: more than half of the uptick in the value of these companies was due to higher sales and margins.

Whether private-equity firms can work this kind of magic in financial institutions remains uncertain, however. Regulators are jumpy about who runs banks: TPG has reportedly promised WaMu’s supervisor that it will not use its holding to exercise control. That rather defeats the point.

Correction: The chart was added shortly after publication of the article.